Tax Accounting.

• Author: Anderson, Kevin

R&E expenses: Automatic accounting method change procedures

In December 2022, the IRS released guidance explaining the procedures for taxpayers to request automatic accounting method changes for specified research or experimental (R&E) expenses to comply with the 2017 amendments to Sec. 174. This item dissects that guidance, provides a broad overview of the procedures, and highlights potential foot faults.

Background

As amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, Sec. 174 no longer allows taxpayers to choose how to account for their R&E expenses--that is, whether to immediately deduct them or capitalize and amortize them. Taxpayers must capitalize and amortize those expenses ratably over five years if research is performed in the United States and 15 years if the expenses are attributable to foreign research, beginning with the midpoint of the tax year in which the expenses are paid or incurred. Further, software development expenses are now considered R&E expenses and are subject to mandatory capitalization and amortization. Under the relevant pre-TCJA rule (Rev. Proc. 2000-50), a taxpayer could choose whether to immediately deduct or capitalize and amortize software development expenses. Amended Sec. 174 is effective for expenses paid or incurred in tax years beginning after Dec. 31, 2021.

Given the vast difference between the new rules and historic Sec. 174, taxpayers with an established method of accounting for R&E expenses will typically require an accounting method change to comply with the TCJA amendments. Generally, taxpayers must file Form 3115, Application for Change in Accounting Method, to make an accounting method change. Rev. Proc. 2015-13 sets forth the general procedures governing changes in accounting method, including eligibility for automatic accounting method changes and the terms and conditions for making an accounting method change.

In part, a taxpayer generally cannot make an automatic accounting method change if it has made or requested a change for the same item during any of the five tax years ending with the year of change. Further, when a taxpayer timely files a Form 3115 in compliance with Rev. Proc. 2015-13, the IRS will not require a taxpayer to change its method of accounting for the same item for a tax year prior to the requested year of change; this is known as audit protection. For automatic accounting method changes, the general rules of Rev. Proc. 2015-13 are supplemented by change-specific rules the IRS issues and updates in its list of automatic changes, which are found in Rev. Proc. 2022-14.

Recent guidance

On Dec. 12, 2022, the IRS added a new automatic method change for conformity with the Sec. 174 amendments by releasing Rev. Proc. 2023-8, which modified the list of automatic changes in Rev. Proc. 2022-14. However, in what appears to be an atypically swift reaction to specific tax planning strategies arising from that initial guidance, the IRS released superseding guidance (Rev. Proc. 2023-11) just 17 days later. The primary difference between the revenue procedures is that Rev. Proc. 2023-11 provides less favorable terms for the accounting method change if the taxpayer does not implement the change in the first required year. Specifically, a taxpayer that defers making an accounting method change for R&E expenses until its tax year following the first year in which it is subject to amended Sec. 174 will not receive audit protection for the first tax year.

Rev. Proc. 2023-11 provides procedures for automatic method changes for R&E expenses in three situations.

Situation 1: A change in accounting method is made for a taxpayer's first tax year beginning after Dec. 31, 2021, for which its federal tax return was filed on or before Jan. 17, 2023 (the date Rev. Proc. 2023-11 was published in the Internal Revenue Bulletin).

This is a transition rule. Under the rule, if the taxpayer reported the amount of R&E expenses on Part VI of Form 4562, Depreciation and Amortization, (filed with its federal tax return) and properly capitalized and amortized those expenses in accordance with the required Sec. 174 method, it is deemed to have complied with the method change procedures, and no further action is required. A taxpayer that did not file its first tax year federal tax return in compliance with those specifications will need to follow the procedures discussed below for a year of change later than its first tax year beginning after Dec. 31, 2021.

Situation 2: A change in accounting method is made for a taxpayer's first tax year beginning after Dec. 31, 2021, for which its federal tax return is filed after Jan. 17, 2023.

In this situation, the guidance allows a taxpayer to file a statement with its federal tax return in lieu of Form 3115 and considers that statement a Form 3115 for purposes of the automatic consent rules of Rev. Proc...